The role of carbon markets in preventing dangerous climate change - Environmental Audit Committee Contents

Examination of Witnesses (Questions 270-327)

MR MIKE O'BRIEN QC MP, MR DAVID CAPPER, MS JILL DUGGAN AND MR CHRIS DODWELL

2 JUNE 2009

  Q270  Chairman: Good morning. Thank you very much for coming in. You will be aware that we had a very helpful session with Jill Duggan a few weeks ago, and we are very glad to see her with you again this morning. Do you have an opening statement?

  Mr O'Brien: No, but perhaps I could introduce my colleagues: David Capper, Head of the ETS team; Jill Duggan, who, as you know, is the Head of International Emissions Trading; and Chris Dodwell, Head of Policy, International Climate Change, in the Department, who will be dealing with particularly with some of the issues around Copenhagen.

  Q271  Chairman: Thank you very much. Would you like to start by telling us what your aims are in terms of the emissions trading strategy?

  Mr O'Brien: The key aim of emissions trading is to enable us to get emissions reductions by setting a cap and to get those emissions reductions at the least cost. That is the primary aim. There are some other subsidiary aims but I think they should be seen in that context. For example, a carbon price will help assist certain technologies and make them much more viable. I have put it in that way, but the objective over the coming decade is to establish a strong emissions trading system so that we can enable the cap to be effective not just over the next decade but over the longer term, up to 2050, and no doubt beyond in due course. We also have the objective of trying to encourage the development of ETS systems in other parts of the world. We know the Obama administration, for example, is very interested in developing it. We know the Waxman-Markey Bill is just completing its process through the House of Representatives and will shortly go into the Senate. That makes a certain amount of progress and includes a cap and trade mechanism. We would then need to link up the various ETS systems so that we can create a global market. We also need to see if we can bring the developing countries into it. We are in the business, therefore, of developing a global mechanism in due course—and I think it is still some way away in terms of being global—which will enable us to have an effective means of contributing, substantially to the reduction of emissions.

  Q272  Chairman: There are a number of issues there which we will pursue in the course of the morning. To start with the issue of the carbon price, when we did a previous inquiry into Emissions Trading a couple of years ago, we felt that there was some tension between the aim of achieving a carbon price which would incentivise faster investment in the low-carbon economy and a desire to prevent costs from rising too much as a result of a higher carbon price, and that perhaps one of the consequences of expanding the scale of the ETS might be to keep the carbon price down. Could you clarify how you propose to resolve this tension? There is no doubt that a higher carbon price does encourage businesses to think about low-carbon investment but it may also feed through into prices. How do you resolve that?

  Mr O'Brien: It certainly will feed through into prices. The whole aim of creating an ETS is essentially to develop a market and that market will have a price. That price will go up and it will go down. We have seen that it was quite high at about €29 and it has dropped to about €10 and it dropped at one point to about €8. We have seen a bit of variability in that market. That is not necessarily a bad thing, in the sense that the aim here is to create a market—and when we were in Phase I it went right down to zero for a period, which I think was a bad thing. We want to ensure that we have a mechanism that has a degree of variability in it—because that is what markets do—but also a level of certainty, because in order to deliver, the market needs to be able to send signals to those who are looking at various kinds of technologies that those technologies will be commercially viable. We need to create an effective market, where you have a reasonable level of certainty, but in so far as you can create it—and remember we are creating something political here—that it moves towards, as soon as we can, an effective commercial market where it is setting a price and where there is a proper system of trading. To some extent we are at the start of that process still, but we can do that and create that market. There will always be a tension between keeping the cost of this low and keeping the technologies in a position where the carbon price encourages. That tension will be there. In a sense, the market is there to help us move through and seek to resolve that.

  Q273  Chairman: Does it mean that if you see the price consistently low you would be willing to take action to try to force it up?

  Mr O'Brien: Are you talking about by creating some sort of floor in the carbon price?

  Q274  Chairman: Or perhaps by reducing the cap.

  Mr O'Brien: Reducing the cap is something that will obviously be looked at at Copenhagen and, indeed, by the EU as part of that process. We have been consistently trying to ensure that we reduce the cap in order to hit an emissions target, but what you are now suggesting, it seems to me, if I have this right, is that we manage the cap merely to manage the carbon price. The primary objective here is to give some certainty in reducing the level of emissions. The secondary objective is to have this market and to ensure that we use that market to support certain technologies. I think we need to keep in mind that we need to look at it in that way. As far as creating some sort of management, so that if it falls below a certain level—and there is a question at what level—we would then intervene by reducing the cap in order to create a much more constrained market or to use other kinds of mechanisms, I am concerned—and let me put this carefully. This is a market which has been created by politicians, essentially, and we are trying to build it into a market which effectively works commercially and achieves a political outcome, an environmental outcome. We do not want to create a market where the main bet is on what governments will do next. The bet, the investment, should be in what is going to happen in the long term in terms of this market. It should be a much more commercial proposition rather than a bet at the next election in Italy. We also need to be careful that we do not create a level of dead weight in these mechanisms so that we, by creating a price, by intervening politically, prevent a market from delivering what it is supposed to do, which is essentially to reduce emissions at the lowest cost. If you are intervening at a certain price and you are saying, "This is it, it won't fall below this level," there is the issue of whether we are then doing some of these technologies at the lowest possible price. That is a second concern I would have. A lot of political interference I think would start to undermine some of the confidence in the market and that would cause me some concerns. Also, at the moment prices have gone down, but they have gone down for a reason. They have gone down in the oil industry, they have gone down in a whole load of other industries because we have a global recession. We have a serious problem across the world in terms of the economy—the biggest problem we have had in decades. That will affect prices, including the carbon price. Should we then start to intervene and start to adjust it? We need to be very cautious about it, but we can, I think, recognise that we are in the early stages of creating a new market and our objective here is to have a market that works. We need not to be so dogmatic about it and say we would never intervene, but say that, in so far as we can, the long-term objective here is to have a limited amount of political interference. Copenhagen will be political interference, but that we limit it in so far as it is as predictable as possible. Everyone knows Copenhagen is going to happen, a deal could arise out of it, that will affect things, that is predictable, but we do not want it being adjusted constantly depending upon our national preferences—and remember that may well be, say, in terms of nuclear, national preferences for a particular technology.

  Q275  Chairman: If we are trying to create a market that is reasonably stable and operates in reasonably predictable conditions, your memo has made it clear that you favour expansion of the scope of the ETS, and we know that aviation is clearly prime candidate for that, each time its scope is expanded that introduces an element of uncertainty and, therefore, the terms on which any new sectors are brought in are crucial. Do you think it is possible to expand the scope in this way without undermining the desirable degree of predictability and stability?

  Mr O'Brien: Yes. I think it is possible to do that. I do not want to sound Rumsfeldian, but there are things that the market knows are going to happen, that it can see. We have indicated that we want to bring aviation in and that, therefore, will create a new area of trading. The market can cope with that sort of change. I think it is more difficult for the market to adjust to constant interventions, sometimes at a national level, which will cause problems for the way in which the EU ETS or a wider global ETS, if we get there or when we get there, might operate. It is always a careful judgment but can it manage new sectors? Yes, providing we give warning that they are coming in and we say what we plan to do in terms of bringing them in, I think that is entirely acceptable and does not create a level of uncertainty for the market which the market cannot manage. If we go beyond that, and we constantly, as somebody put it to me, "mess about" with the way in which this market operates from a political point of view, it may bring short-term benefits but in the long term we undermine the way in which the development of this market might occur.

  Q276  Chairman: How will you judge if Phase II has been a success?

  Mr O'Brien: I think we have to see whether we hit the emissions targets under Kyoto. My view, as I have set out to you, is that the objective of the whole mechanism, the whole system, is to see if we can reduce the level of emissions. That over the long term is the test. But there are other tests too with Phase II. That is the big picture test, but the others are: Are we creating a market which is more sophisticated than certainly it was under Phase I, which was really just a pilot. Are we able to deal with some of the problems that have developed—not just in Phase I, which we sought to resolve to some extent in Phase II and have had a fair degree of success in resolving. There are still issues around CDMs; there are still issues around the administration of the ETS; there is still a lot of refinement to be carried on, the methodology, the accounting. I know everyone thinks it is very slow and everyone wishes it could be done more quickly, but we are creating a very large, very sophisticated, very important mechanism, and we are having to refine it constantly. Will we at the end of Phase II be in a position where we have identified some more of the problems, resolved some more of the problems, so that we go into Phase III with a clearer view? We will in Phase III probably not have got it perfectly right, but we will still be in the process of developing markets. As we all know, markets tend to develop over a long period, but it will constantly require the level of long-term political steer but a commitment still to have a trading system rather than to have a politically guided system.

  Q277  Chairman: Do you have any concrete evidence that emissions trading has so far produced a reduction in emissions?

  Mr O'Brien: There has been a lot of criticism of Phase I, but if you look at the Massachusetts Institute of Technology Report that suggested that Phase I had produced a 4% reduction. Does it work? The solid evidence we have up to now is that—and the MIT report seems to suggest that there is some reason to believe that, yes, it works, and even in a pilot scheme that was much criticised—quite rightly—it seems to have produced some reduction. The NAO report which has looked at this has said that 64% of the businesses which operate in this scheme, about 900 installations in the UK, take into account that there is an ETS system in terms of the decisions that they make. We also have a market which is absolutely massive and trades 25 million tonnes a day. So there is a lot of work going on in this market in itself, and therefore you are creating a commercial opportunity, and that with a cap, and a cap that will progressively tighten, aims to reduce emissions. I think there is quite a significant amount of evidence to show that the system over the long term will work. Up to now it has produced some results but we have to work with it and try to refine it and make sure we have a system that delivers in the long term.

  Q278  Chairman: Would you agree that because the severity of the recession understandably was not foreseen at the time that the tighter caps for Phase II were being set, unfortunately, it will be the recession that cuts emissions now in Phase II and not the cap?

  Mr O'Brien: It certainly is the case that as a result of the level of activity in the economy going down we will see the level of emissions going down. The test is not so much whether the recession would have done it or whether the ETS would have done it, but whether or not we had a recession, would the ETS have done it. I think there are some grounds for believing that the answer to that is yes. Also, because companies, 64% of them in the NAO Report, are indicating that the ETS is affecting their decision making and if it is the case that they are making decisions based upon the ETS, then I think we can say that, in any event, recession or not, the ETS is having an effect by reducing emissions because companies are saying it is having an effect upon the decisions that they are making and because the market is building now. The prediction is that It will be worth £97 billion in the course of this year.[1] The EU ETS market was worth €63 billion in 2008, and the global market was worth €86 billion. That is a big market. That is bound to produce an impact. Therefore, I think we can say that in any event the ETS is having an effect. Whether the recession will have a bigger effect than the ETS, we will have to wait and see. If that is the nub of the question you are asking, I think we will just have to wait and see, but I think we can say with some reasonable confidence that the ETS is having an effect in any event.

  Q279  Dr Turner: Government climate change policy places a great deal of reliance on the EU ETS in achieving a policy outcome of limiting temperature rise to no more than 2°C. Given that background, one assumes that there ought to be some numbers attached to this policy and to the ETS. What levels of CO2 equivalent reductions does the Government feel that the EU ETS needs to deliver within the EU to meet the 2°C target?

  Mr O'Brien: To some extent this will depend on the outcomes at Copenhagen. As far as the UK is concerned, we want to see a 16% reduction in our emissions in sectors outside the EU ETS up to 2020, and if we have a deal, a 30%, say, deal, across the EU as a result of Copenhagen, we will be looking at 26%. That is overall outside the EU ETS. What contribution ETS will make in addition to that—and remember you cannot place all weight of climate change policy on the ETS alone—

  Q280  Dr Turner: It would be foolish.

  Mr O'Brien: It is a very important part, but there is a range of other policies which we are pursuing in any event. We have to look at the way in which we reduce emissions as a whole, across the board. We are taking the view that we want to see these reductions and we think the ETS will make a substantial contribution to it, but the extent of it will be dependent upon the way in which the ETS operates. The 16% is in non ETS areas, but I think in terms of what we expect from the ETS itself, perhaps David might set out some of the figures.

  Mr Capper: The Phase II cap across the whole of the EU is set at just over two billion tonnes of CO2 equivalent. The cap that has been agreed in December as part of the EU climate and energy package takes us down to about 1.7 billion tonnes by 2020. That in itself is a 300-400 million tonne saving across the EU. If you compare it to the baseline figures, the verified emission data for 2005, which are just over 2.2 billion tonnes, then you see it is about a 500 million tonne saving. In terms of the amount of emissions covered by the UK within the EU ETS, this is difficult to calculate for 2020 because we have a number of EU procedures and EU discussions that need to happen before we get to the point where we will know exactly what numbers of allowances we will be auctioning in Phase III and also the numbers of allowances we will be giving free to installations on UK territory. The estimates that the European Commission made in their impact assessment on the EU 2020 package is that the combination of those two things, the free allocation and the auctioning, would lead to emissions of around 199 million tonnes in 2020, which is below the current levels. We saw 265 million tonnes, I believe, as the 2008 emissions from the UK installations. That hopefully gives you some order of the magnitude, that really very, very big savings happen in those sectors covered by EU ETS across the whole of the EU. A saving that delivers something like 500 million tonnes over 15 years is really a pretty significant carbon saving.

  Q281  Dr Turner: Can we look at the process of cap setting itself. Has that involved former scientific modelling using numbers to arrive at a cap which will produce the result we want, or has it in fact been a pragmatic process of what can be politically achieved within the EU?

  Mr O'Brien: I think it is part of both. Perhaps David could go through some of the technical stuff and then I will deal with the political side.

  Mr Capper: The emissions trading theory is that you set your overall target in relation to what the science is telling you. This is why the EU has ended up with this 20% unilateral target or the 30% target assuming a comprehensive international agreement at Copenhagen. Under those targets, you need to make a decision about which of those emissions will be covered by the EU ETS and which of those emissions will be covered by other policy instruments. The decision that the EU faced in December last year was to determine the split of effort between those sectors that are covered by EU ETS and those that are not covered by EU ETS. The logical decision from an economic point of view that the EU came to was that you would do it on the basis of economic efficiency. The whole idea behind the EU ETS is that you reduce emissions at least cost. It was agreed in December that two-thirds of the effort to meet our 20% target will come through the EU ETS cap, and so you have that process where you have the overall targets which are determined by the science and what is politically agreeable and then you have the process by which you try go get those emission reductions at least cost. Because of the efficiency of the EU ETS and the abatement potential within the sectors covered by EU ETS, we have ended up with this position where EU ETS sectors will reduce across the EU by 21% compared to 2005 emissions by 2020.

  Mr O'Brien: Chris will say something on the science.

  Mr Dodwell: Global emissions are the key thing in terms of the 2°C target, because a tonne of carbon emitted here is the same as a tonne of carbon emitted anywhere else. The 30% target which the EU adopted was adopted in line with the IPCC recommendation that we needed to have, in Annex 1 terms, within the 25-40% range by 2020 and that other developed countries also needed to take comparable effort to come on board with those kinds of targets. Basically, this is aiming towards a global peak in emissions by around 2020 and then decreasing to very low levels, and at least half 1990 levels, by the middle of the century. There are a number of ways you can draw these trajectories. You can either frontload effort, which requires obviously early political will, or you can delay effort, which requires belief in the technical feasibility of rapid reductions that can turn things round. We are doing some further work with the Hadley Centre on trying to establish what these trajectories really look like in global terms and then how you can relate that to target the US is willing to take on but also the deviation that you need from business as usual from developing countries as well. The EU 30% is consistent with the IPCC's recommendation. As David explained, the rest of the target for the EU ETS flows down from those headline figures.

  Mr O'Brien: In terms of politics, obviously how much you are able to frontload depends on your domestic politics. We and Italy may have different views on how much you can afford to frontload and obviously the issue is still a very moot one in the United States.

  Q282  Dr Turner: We have heard some interesting comments from David Kennedy, Chief Executive of the Committee on Climate Change, that in Phase III of the EU ETS the UK purchases of credits would mainly be paying power companies in countries like Germany and Poland to switch from coal to gas. In other words, our energy bills would be going up to pay German power companies to do what they should be doing anyway, and in no way would this be financing a step change in low-carbon technology. Is this an intended outcome of the policy? I am sure it is not.

  Mr O'Brien: It is not an intended outcome. The overall aim is to reduce emissions and, clearly, depending on carbon capture and storage issues—but let us leave those aside for a moment—the move from coal to gas will contribute towards doing that, but the objective is to move more effectively towards low-carbon generation rather than moving simply to gas—which of course has quite significant emissions in any event.

  Q283  Dr Turner: Does it not suggest that there is a weakness in the cap-setting mechanism? If that is what is happening in Germany and Poland, clearly the correct incentive for Germany and Poland would have been to tighten the cap on Germany and Poland rather than them being able to buy their way out at our expense.

  Mr O'Brien: We are part of EU ETS. Some countries are taking a somewhat different view from us in terms of how far they are prepared to move and how quickly and how protective they want to be with some of their industries. Whilst you are right in saying that from the UK's point of view, as a country which is seeking to take a lead in encouraging the process of reducing emissions, we would hope that other countries, including countries like Poland, would have a view that they too would want to see significant reductions, they, at the same time, are also concerned that for all sorts of historical reasons they want to continue to support the power generation that they have for a bit longer. They are part of the system but they have problems which they feel domestically they have to work through. In a sense, it is precisely the point that I made earlier, which was that for ourselves, for Italy, for Poland, the degree of frontloading on all this depends on what the domestic politics will wear. Here we have a broad consensus that we need to deal with this issue. In some other countries there is a level of debate and also a level of concern about the impact on their economy—which is much greater than ours.

  Q284  Dr Turner: How are all these processes going to contribute to the development of low-carbon technology development? What contribution do you think the EU ETS process is going to make towards low-carbon technology development?

  Mr O'Brien: It will ensure, as the NAO Report says, that companies look when making decisions at not just what the Government and the EU is suggesting they should do but at what the emission trading system encourages them to do and also at where the penalties would be if they do not start to cut emissions. The more efficient companies will see that there are benefits for them; the less efficient companies will see that there are downsides, disadvantages for them, and hopefully adjust their behaviour. In Phase III, when we are looking at some of the benchmarking, we see that there is quite a lot of encouragement there for companies in particular sectors to match the best in their sectors. The average of the top 10% is the benchmark. We are looking at trying to find ways in which we encourage companies to do the best that they can in terms of reducing emissions. Will it have an effect in the UK? Yes. In fact, all the evidence is that it is already having an impact.

  Dr Turner: We will come back to that.

  Q285  Colin Challen: The attention in Washington as to the Waxman-Markey Bill—which is being reduced, it seems, in its ambitions as it goes through Congress: I think it is now down to 17% CO2 cuts, 2020 target, but based on a 2005 baseline, unlike our 1990 baseline—effectively, as I understand it, it is equivalent to 4%. What implications does that have for our 2020 targets in the EU, because we are seeking to be a lot more ambitious than that?

  Mr O'Brien: We are. I spent four or five days in the United States the week before last talking to some people from the administration and from Congress, and also from some of the think tanks and the companies, about, among other things, Waxman-Markey. It is clear that this has quite significant implications. It is a major step for the United States from the previous eight years. I think we need, first of all, to recognise that. The debate in the United States is quite different, it seemed to me, from the debate here. The debate there is primarily around energy security rather than climate change. Climate change is there, but as a secondary issue, whereas here climate change is very much a leading issue and energy security is important too. The debate in the US is different. We have seen quite a broad-based bill and a very serious attempt by Waxman and Markey. They are both seriously committed on these issues but they also operate within a system where they know they have to do compromises. They have tried a very broad-based bill. It has a number of controversial areas in it, some of which will contribute towards dealing with global warming—particularly some of the issues around nuclear are quite controversial, and they have tried to steer clear of them—but we also know that when it gets into the Senate the bill is going to have a lot more difficulty. We therefore need to watch with care how this develops. If they are able to set up a cap and trade system in the United States, that in itself will be a major advance. That will be enormously important for us and of great benefit for the EU ETS and of great benefit for dealing with emissions on target. Will it be set up in the way we would best like? Well, they are going to make their own decisions rather than being told what to do by us—that is very clear—but it is an ambitious bill within the American context. It is subject still to a lot of debate. I suspect there will be some further amendments to it. All the indications I got were that there was a lot of controversy still around it. What are the implications for us? I think the big one is really what are the Americans going to do at Copenhagen. If they can get Waxman-Markey through this year, that is the best window of opportunity—because next year is into the mid-terms, and this produces all sorts of political issues for them, particularly in some of the coal states. The question is: What is the administration's point of view going to be? If they have got Waxman-Markey through by the end of the year, or it looks like it is going to get through within a month or two of the start of the following year, I think the administration is in a stronger position. The administration's indications for Copenhagen at the moment seem to be that they have learned some of the lessons of Clinton on Kyoto (that is that Clinton wanted Kyoto but Congress did not) and the impression I got from talking to various people was that the administration had taken the view that they wanted to ensure that whatever negotiating position they had at Copenhagen was one which they could deliver through Congress. They did not want to be back in the same position where they just could not deliver this agreement. I think Waxman-Markey will have quite an important impact for that on Europe and an important impact too in terms of the way in which we are able to negotiate and the deal we are able to negotiate at Copenhagen. If we are able to get a cap and trade system at whatever level that operates effectively in the US, that is a big step forward and we must not underestimate the importance of it, even though it may not be at the same sort of level that the EU has. One additional point is of course if it is all set at a different level it makes linking up the systems a bit more difficult, but I think in a sense we have to work our way through that process over the coming decades, developing this system by linking up various ETSs that have been created is not of itself going to be an easy process.

  Q286  Colin Challen: I would agree with the statement that is taking a big step forward, particularly on the record of the last eight years, but it does beg the question of what benchmark we should put in place—and I assume that we ought to put a benchmark in place—in Copenhagen for our intended budget of 30% by 2020. Effectively what the Americans might be offering—and this is their best offer—is worse than Kyoto. Kyoto was 5% based on a 1990 baseline. If the Americans are talking about 4% on a 1990 baseline, how is it we can tell the public that we are going to increase our targets by 2020 merely because the Americans are offering us that? That surely is not the basis of a deal with Copenhagen.

  Mr O'Brien: I think these things are going to have to be negotiated. The American administration will come to Copenhagen and we are hoping that they will come with a view (a) to making a deal—which is important—but (b) to doing it on a basis that will seriously drive down emissions. At the moment there is a lot of contact going on, not just with the United States and the EU but also with other countries, to try to feel out what the negotiating positions are going to be at the end of the year. The picture is still to some degree opaque. The EU set out broadly where we want to go in January but the US is still working its way through some of that process. If it is the case that the US have a view about where they are going to set their limits and that is very difficult for us, obviously that is what negotiations are about and we will have to see how that comes out. I mean, it is difficult to predict.

  Q287  Colin Challen: I fully understand the difficulties. This is perhaps the most intractable issue on which to negotiate. A secondary point about Copenhagen, given that we are talking of the 30% target if there is a deal, is what constitutes a deal. People can sign an agreement, just as they did in Kyoto, and then, as far as the States are concerned, they have the same problem now as Clinton faced and that is getting the treaty ratified.

  Mr O'Brien: Yes.

  Q288  Colin Challen: A big difficulty: 67 majority required in the Senate, I understand. Do we say, therefore, that we would change the third phase of the ETS to a higher target purely on the basis of people agreeing a deal, or is it based on ratifying the deal? That is a key point as we have had all the experience of Kyoto. What is the timing involved? The third phase starts in 2012. Copenhagen or Kyoto plus whatever it is should be ratified by 2012 to be continuous. What is the timing? How do we start planning?

  Mr O'Brien: At the moment we are setting out where we want to be and what our proposals are. Once we have got through Copenhagen—and we all hope we will get to a deal—we are then in a position where we will have to make some judgments about what is going to be delivered and by whom. It will not just be the United States that we are concerned about, but the United States will be an absolute key player in a successful outcome. We are going to watch very carefully what is likely to be ratified by Congress. I have indicated where I think the administration are looking at it. You are asking what do we do and when do we announce things: Do we wait for the ratification or not? I think we look at where we are when we have the deal and we then make a judgment about where we go from there. We are in a position where we are trying to set an ambitious agenda. To some extent, some in America see it as much too ambitious. We take the view that if we are going to hit some of the targets, if we are going to have the reductions in emissions that we need to have, then we need to be very ambitious indeed, but there is still domestic politics in the US and other countries that we have to take into account. I know that Chris wants to say something about the US position.

  Mr Dodwell: The Waxman numbers that you have been citing refer to the 85% of the economy covered by their cap and trade system and it is important to recognise that they do envisage additional reductions being made on top of that. First, through a significant portion of finance going to finance reductions in international deforestation that could add up to a further 10% on top of the numbers that you were mentioning. This would take them to around 15% against 1990 levels, since we are viewing this as a "target" rather than necessarily where the reductions actually take place. Secondly, there are complementary measures in the Bill standards and other policies for the energy sector. Also, the Obama administration have just announced a new initiative on vehicle standards. It may well be, therefore, that there are additional measures that take America further than the headline number that you have just been citing. We are really looking for countries to come forward with initial propositions and then the ability to move forward further, to higher targets. We have just seen the Australians in the last month or so come out with a revised target where they will say they will move to 25% under the right sort of political conditions at Copenhagen. The Japanese will be announcing a mid-term target later this month. It looks like that, again, is going to be some form of unilateral target which might suggest that it could go further under appropriate conditions or by the use of financial flows, offsets into other countries. Then, finally, just to come back to the process in the EU, what is set out in the European legislation is that the Commission will review the situation after Copenhagen on the basis of what the agreement looks like and then will come forward within three months with a proposal on how the EU should move forward, including where the relative distribution of effort should be between the traded and non-traded sector, and that would be what would lead to the renegotiation of the ETS Directive and the legislative measures covering the non-traded sectors.

  Mr O'Brien: When I was saying "we" I was talking about the EU at that point. The UK has a view about what the EU should do. The EU will then have to work through its own negotiations with the Commission and agree what it decides collectively to do.

  Q289  Colin Challen: In terms of the proposed increase of 30%, what is your view on how much of that should be domestic effort within Europe or how much of it is going to be, if you like, bought in from developing countries?

  Mr O'Brien: This is very important. The maximum amount of domestic effort should be made, but we also have to recognise that the global phenomena of global warming means that we want to encourage developing countries also to make an effort. There is not a complete answer to your question because we will need to see what the outcome of Copenhagen is for developing countries and whether CDMs or something similar, sectoral deals, or however we are going to go forward in developing countries. Let us see where we come out at the end of Copenhagen, with the mechanisms that are available for developing countries, and, therefore, how much contribution the developed countries have to make and what their role is, what the nature of those contributions is and how they are going to be made, and whether we are keeping CDMs and in what context, in what reformed way. There are a lot of question marks around this, but as a basic proposition, a sort of position of principle, we want to see the maximum effort made domestically. We want to keep open the option of purchasing various kinds of credits because they can have a significant effect in other countries—and this is a global issue—but we have been clear in saying that we want the maximum amount of effort domestically.

  Q290  Colin Challen: If that 30% does not kick in and we stick with the 20%, what happens after 2020? Because everything is going to have to be upped, the ambition will have to go practically off the scale. The Kyoto experience does not inspire a great deal of confidence that we can up our efforts after a long period of endeavouring to get 5%, regardless of our own UK position or that of Germany, which, for various reasons, has hit he Kyoto target.

  Mr O'Brien: I was listening yesterday to Mr Tanaka from the International Energy Agency. He gave a lecture at Chatham House. It was on the record, so I can talk about it. He was emphasising the amount of expenditure that there needs to be to make the emissions reductions, the change, the energy revolution that we need, and comparing it to the stimulus packages that have been announced in the last year. He claimed that we are talking, over a longer period, of figures six times that amount, just in terms of the level of investment, much of it coming from the private sector, that you have to put into making the level of change happen. I have not had a chance to look at Mr Tanaka's figures, so they are not government figures, but you are right to say that if the level of ambition post-Copenhagen is not as high as we hope it will be—and there is a great deal of ambition on the part of the UK that Copenhagen should succeed and deliver significant changes, but if, say, it does not work out that way—by 2020, yes, we will be in a very difficult position worldwide because the level of effort required to be made will be enormous, and Mr Tanaka's figures may well be on the low side by 2020. Who knows?

  Q291  Chairman: Looking at the global position, you have touched once or twice on the question about how the EU Emissions Trading System might be linked up with the wider system realistically? When do you think we could see a global system which is robust enough to drive a carbon price which will incentivise investment in low-carbon economies?

  Mr O'Brien: I do not have a clear date. Jill wants to say something on this.

  Ms Duggan: We have a European position on how we think that might be developed—which is probably optimistic and ambitious, but there is no harm in being optimistic and ambitious—which is to have OECD countries, have a series of linked trading systems by 2015 with major sectors from advanced developing economies linked into that by 2020, looking towards the development of a global carbon market at a company level, company-based trading, by 2015, based on the assumptions that developing countries reach a certain stage of development before joining into that cap and trade, so that they get the benefits of the Clean Development Mechanism or its successor prior to that. We are looking at, over the next four decades, building up a carbon market. Our experience in the UK and Europe is that we have learned an awful lot over a relatively short space of time, but there is still more to learn, and so certainly over the next decade there will be a step-by-step process towards this.

  Q292  Chairman: Are we arguing actively with other countries to try to encourage them to move in this direction?

  Ms Duggan: We are certainly talking to other Annex 1 and OECD countries about the benefits of linking long-term, particularly linking company-based trading systems. I think our experience would indicate, particularly our pilot phase of the European Trading System, that it was useful for most trading systems to run on their own for a couple of years to deal with any unintended consequences. It is not an immediate goal; it is a medium-term goal where other countries are open to those arguments, but they do need to deal with domestic acceptance first.

  Q293  Chairman: Are you encouraged by the response that you are getting to these conversations?

  Ms Duggan: I think we need to recognise, as in the UK and Europe, that you need to get political acceptance of cap and trade, which is something that they are working very hard at in Australia, in the US and in Japan and South Korea and other countries. The immediate goal is to get acceptance for cap and trade and to get cap and trade running. Once you have done that and you can deal with that within your own domestic legislation, that is the time to start looking outwards towards linking. Prior to that there is a need to be aware of what you might need to design into your trading system in order to make it linkable.

  Q294  Chairman: Has any thought yet been given to how we could link together schemes? Some will have weaker caps, some will allow for a much greater use of offsets, some might want to have price ceilings or price floors, but there are a number of different characteristics which people could incorporate. Certainly our discussions in Washington recently made me anxious about the potential of offsets, for example, in the US cap and trade system. Has work been done on how you can make all these different schemes compatible?

  Ms Duggan: There has been a certain amount of work. The work that has been done to date indicates that there are technical fixes for everything pretty much, but of course it is the political certainty and the transparency, as far as business is concerned, that is going to be important. I think that will be a negotiation and probably a certain amount of compromise between trading systems to do what we have learned in Europe, which is that we have learned that we need to harmonise to get that transparency over time and Phase I to Phase II to Phase III has taken us in that direction. Other nations are not yet in that position and I think you need to start trading quite often in order to recognise the need for harmonisation.

  Mr O'Brien: Australia and New Zealand are in a position where they are looking to start in 2011. The Japanese have their voluntary scheme. The South Koreans and Taiwanese have expressed interest: they want to do something, but what will they do? In a sense, we are in a situation where we do not know what the other ETS schemes will be like. Much of the work we can do now, in a sense, is to speculate and to try to work out how we can deal it, but, as Jill says, the view is that there are technical fixes to these things and that should enable us to begin some element of linking up. The view generally from talking to other countries is that they envisage a link up—of course, always on their own terms.

  Q295  Mr Caton: Minister, in your opening statement you foresaw us continuing to use cap and trade even beyond 2050—at least as a possibility. Lord Stern has argued, however, that in the years towards 2050 the scope for trading will get less and less as the opportunities for low-cost abatement dry up and the countries have to do more at home. He says, "We would expect the volume or trade to rise over the next 20 years or so and then start to fall. That would be a feature of success." In your opinion, when would emissions trading effectively cease, with all countries having to concentrate on decarbonising their own economy?

  Mr O'Brien: I do not know the answer to the question, in the sense that it all depends. I suppose that is the only answer I can really give. But you are right that Lord Stern took a view that the volume of trade would potentially, in due course, start to reduce and countries would have to find technological and other means. We see the ETS as an enormously important mechanism to help us move towards less emissions but we also know, all of us, that there will be a range of other ways in which we do this. There is domestic government action in each country. We have the energy efficiency and insulation projects announced last September in this country and a range of other things that we are doing. We know that other countries will also develop their own schemes and technology, the introduction of electric cars and the way in which we have a more sophisticated grid, the so-called smart grid, where you can manage much more effectively the amount of emissions that there are and the amount of use of energy. There are a range of ways in which this market will change over the years. Whilst I think Lord Stern is probably right that the volume of pure carbon trading will reduce in the long term, quite what the nature of the market will be in the long term depends on a number of other technological as well as other kinds of changes. It is, therefore, very difficult to predict what exactly the ETS will look like, and we do not really know, in 2040/2050, so I am sure, as sure as we can be looking into crystal balls, that there will be a market mechanism ahead there which will ensure that there is a commercial incentive in order to reduce the level of emissions, that the amount of carbon emitted hopefully will be substantially lower and, at that point, you are in a position where the level of trade reduces, so it is difficult to predict, but there will, I suspect, be some kind of trading scheme into the future. The detail of how and what it will look like, I bow to Lord Stern and his views.

  Q296  Mr Caton: Returning to what we were discussing a little earlier, the objective of creating a world-wide carbon market, can I quote from the evidence that we had from EDF,[2] who said that the evolution of a global carbon market will take too long "to meet the specific needs of the UK, where decisions on the role of low-carbon technologies in replacing capacity over the next ten to 15 years need to be taken now". By the time the EU ETS has developed into a global carbon market, exactly how relevant is it going to be to the kinds of actions that we need to take to decarbonise the UK?

  Mr O'Brien: Essentially, what you are looking at is the way in which we have support available for companies like EDF, for a carbon price and so on. They have taken the view that they want to see some support for renewable targets and for the development of nuclear as well through a carbon price, and quite how, they are not entirely specific and I would be interested to know precisely what they have said would be their answer on this. They have various different views about what they would want to create, so I would be interested in how they would actually deliver on this.

  Q297  Mr Caton: Do you share at all their concern just about the timescale?

  Mr O'Brien: Not to the extent that they have put it, no. I think that what we do need to do is make sure that we have other mechanisms which will ensure that we deliver the reductions, and those have to happen in any event, but I think you have to look at where EDF are coming from and precisely what it is that they are looking for in terms of their commercial position. They have been a very forward-looking company in many ways, but they have also been a company that is operating in a market.

  Ms Duggan: I think you are right in that it is very difficult to get a very high carbon price in the short term that sends those very strong signals. I think what we have learnt in Europe actually is that the continuation of the market has been particularly important. The Minister has quoted figures from the National Audit Office and also from the Point Carbon Survey which found that participants, because they have certainty on the continuance of the emissions trading system, do take its future existence in account and the carbon price into account in making investment decisions. However, we also have other policies that are intended to help induce the right behaviour in the short term, so in Europe we have a renewables target for 2020 as well as the emissions reduction target which sends that very, very strong signal to EDF and other companies about the direction of travel that is required. We have various funding available through a variety of measures and a recognition that there will be funding available, and David might want to say something about the use of auction revenues across Europe post-2012 which can help support some of those technologies which will be required in the shorter term.

  Mr O'Brien: I saw the comments of Vincent de Rivas the other day in the newspaper, saying that we needed to have more intervention to hold up the carbon price. I know that that is his and EDF's view, that, in order to ensure that the commercial propositions around nuclear are as good as they want them to be, there should be that level of intervention. I think, for the reasons I have already set out and I will not repeat them, there are questions as to whether we should take a political view and intervene and start supporting prices. We have said that, as far as nuclear is concerned, we are not providing subsidies for nuclear and that is our view. We think that nuclear will actually wash its face itself and that is the view that EDF have taken up to now, interestingly, as the carbon price has fallen somewhat, as have other prices, due to the economic situation globally, but EDF have taken the view that they would make the statement that they have in the last few days. I think David wants to say a few words on this.

  Mr Capper: I was actually only going to reflect on your previous question about what trading will look like in the longer term because it is, I think, a surprisingly poorly known fact that in terms of the EU ETS the world does not stop in 2020. I think some people have the idea that what was agreed in December is that we have set our cap to 2020, but we have not said what happens beyond that, whereas actually what was agreed in December does set the cap out in fact all the way until it gets to zero, which is about 2066. Now, of course after Copenhagen, assuming a successful agreement, we would hope that you would have a tighter cap which would reduce even more quickly than that, but I think that does give a good indication of where in the longer term we would see trading going.

  Q298  Colin Challen: Just following on from this theme, I am a bit worried when we think too much about the longer term and try perhaps to avoid getting our house into order more immediately. The National Audit Office, in their recent report, where I think the facts of that report were agreed with DECC, concluded that the current price of EU ETS allowances is "insufficient to stimulate major investment in low-carbon technologies". Now, given that this report was agreed with DECC, do you agree with that conclusion and what is being done about it?

  Mr O'Brien: Well, there are other mechanisms in place to encourage low-carbon technologies, but, in a sense, it comes back to Martin's point which was to what extent and indeed Tim's point about the extent to which governments should be intervening here, and I think we need to intervene in particular ways to encourage, as we have done with the RO, the development of certain kinds of renewables, and we have indicated that we will support particular kinds of renewables and there is, in a sense, a consumer subsidy which is in there to develop those renewables, so we are not entirely reliant—

  Q299  Mr Caton: That is a recognition of the failure of the ETS, is it not, in driving low-carbon technologies?

  Mr O'Brien: No, far from it. It is a recognition that you cannot put all the burden on ETS. ETS is a mechanism, not the only mechanism, a very important mechanism, but we have got to have a range of other mechanisms that will enable us to deliver the amount of emissions that we need to make. The idea that the ETS and the cap of itself can deliver everything is just wrong. We are going to have to pursue in the coming decades, and indeed now, a range of policies which enable us to reduce emissions and to move to low-carbon technologies of different kinds, and some of those are low-carbon technologies we have decided that we will give subsidy support to through the consumer and some of them we have not. I have got the signals from colleagues who want to come in and add something to this.

  Mr Capper: I think that this is a widely accepted strategy for reducing emissions and I think it goes back to, as somebody mentioned earlier, Lord Stern. The Stern Report said very clearly that what you needed was to put a price on carbon, which is what the EU ETS does, but that, in order to reduce emissions, you do not just need to do that, you also need to do other things, and one of the other things that you need to do is develop specific mechanisms to bring forward certain technologies that will be needed for a low-carbon future, so, as the Minister said, what we are doing on renewables and what we are doing on CCS are things which complement putting a price on carbon. It is not a kind of either/or, but you need both of these things in order to move to a low-carbon future.

  Q300  Colin Challen: But an infamous DTI leaked document a couple of years ago, widely reported in the press, argued that we should not invest too much in low-carbon technologies through direct public support because it would damage the ETS. Those arguments are still quite live, I imagine.

  Mr O'Brien: Well, I have not particularly been party to any debate like that in recent months, certainly since the setting up of DECC, but it is the case that, in anything you do, you have to look at the implications for other policy levers. What we are doing is developing an ETS which, we hope, will be a significant policy lever that will have substantial benefits for decades to come, but I would just repeat that it is only one of a number of policy levers and we have got to pull the whole range of them in order to get the sheer level. I think there still is not out there broad public comprehension of the degree of change that needs to be undertaken if we are to reach the levels of reductions that we have to do. The sheer scale of the level of investment is massive and it will require big investments in nuclear, in renewables, in the grid, in wider connectivity over a number of decades and at a high, sustained level of investment. What we have with the ETS is a market mechanism which drives down the level, we hope, or the aim of it is to drive down the level of emissions and to create a market which will encourage the development of those low-carbon technologies. Taken together, we can achieve this green revolution. I often say to small groups of businessmen in the energy industry who are sort of very perhaps conservative in their outlook in all sorts of ways, basically the Che Guevaras of the energy revolution, that the scale of what they are going to do is going to be massive and they have got to grasp the sheer scale of this and they and their companies are going to be making these changes over a number of decades. This is a long-term thing, and the ETS is one of the levers that we will use to deliver this, but we will use a lot of other things as well.

  Q301  Colin Challen: I agree that we need a portfolio of things, including cap and trade, but is it not true that the ETS has been the weak link in the chain up to date, and perhaps it will get better, but perhaps one of the ways it should get better is with a tighter cap which drives up the price of carbon? Let us forget floors, let us just talk about a tighter cap because is that not one way that we should address this problem of its weakness?

  Mr O'Brien: Well, a tighter cap for ETS is certainly a mechanism that of course we are looking at both at Copenhagen and beyond, so a tighter cap is part of the mechanism, but putting everything on to that and saying that that of itself will deliver everything is not going to be enough. Has ETS been a weak link? Well, the weakest part of ETS so far, and we are only at the start really, has been Phase I and, even there, MIT suggest we had a 4% reduction. Now, if it had been tighter and the cap had been tighter and we had not had all these surplus allowances, maybe we could have delivered a lot more. Well, of course, yes, in that sense, it was weak, but it was also a success, so there is not a simple way in which we can either dismiss it or say that ETS has been a great success. We are at the start of developing a mechanism that will have to define itself, get more sophisticated and change significantly over a longer term so that it starts to deliver more effectively the things which it is there for.

  Mr Dodwell: A lot has been said on the idea of trading schemes being effectively necessary, but not sufficient, and I think that is clear. As David suggested, we are over time wanting to send out a long-term signal that we are moving to a zero-carbon energy economy and the cap effectively does reduce to zero. That is what needs to happen over time and to get to those parts of the mitigation cost curve that are more expensive, you are going to need complementary measures, as we are doing on CCS. But, in the meantime actually, with the abatement techniques and the abatement that takes place, other things will play a role, so the example you cited of moving from coal to gas, that actually is a legitimate abatement technique. Were it not for the establishment of a carbon price, coal would continue to be burned in those plants in Germany and in Poland, and it is a positive signal that people have seen that a carbon price is effectively changing their behaviour and reducing global emissions. The other thing I wanted just to comment on was actually the interdepartmental working relationship which you sort of alluded to. Let us not shy away from the fact that there is a potential tension between different objectives, an objective of security of supply and an objective of low-carbon technology, and the challenge that we face and the challenge that DECC was put in place to address is how to resolve those two things and take them forward in a way which not just reflects both of those imperatives, but also in a fair deal for consumers, for industry and business.

  Q302  Colin Challen: The specific point made in that leaked document was that, if you invest public money and subsidise low-carbon technologies, that depresses the price of carbon and, therefore, the ETS. That was the argument that was used in that document and, I guess, that must still be true.

  Mr O'Brien: Well, it depends on the cap, does it not?

  Q303  Colin Challen: Well, yes, that is why I came to the point about the cap.

  Mr O'Brien: If you put in your subsidies and encourage low-carbon technnologies, yes, I suppose, if your cap stays at a certain level, that will depress the price of carbon, but, if your cap reduces at the same time as you are doing the subsidy, then you have still got the market, therefore, and a price should be being set within that market.

  Q304  Colin Challen: And that work is being done presumably?

  Mr Dodwell: But, equally, if you are complementing an existing price in order to effectively encourage the use of technologies that would not be picked up at that carbon price, then they do not work against each other, they complement each other.

  Mr O'Brien: There is also a need sometimes, as we are doing with CCS, to decide that the market simply will not fund a particular change in technology and there has got to be a political intervention in order to create a funding stream for that.

  Mr Dodwell: I did just want to make one other point about the working relationship and the political conditions in the UK. I think we have to recognise how much ahead of the field we are in terms of the resolution of tensions between different departmental priorities and in terms of the political conditions in comparison with other countries. You see the debates in Australia, you see the debates in Japan and the debates in the US and you do not have the same coincidence of objectives and of aims. You have industry effectively pushing back against the low-carbon agenda because they are concerned or they are in a state which, you will recall, we were perhaps in before the introduction of the EU ETS. One of the things, I think, we do have to consider, and I know the Committee is active in pursuing this, is sharing our experience of actually how you can overcome initial resistance from stakeholders so that they can begin to see the prosperity agenda here, that there are actually opportunities in this move to low-carbon technologies which allow you to address both the climate change objectives and your energy security objectives at the same time.

  Q305  Joan Walley: Minister, I am still perhaps concerned that there just appear to be mixed messages coming out because, on the one hand, the evidence that you gave to us says that the EU ETS provides "a long-term price signal sought by investors" and just now you told us that obviously that is not the only thing, it is part of a whole raft of measures that is going to deal with this. When we had EDF sitting in those same seats a couple of weeks or so ago, they told us that they did not believe that the long-term signals would be there, at the moment, beyond Phase III. The implication of what they were saying is that, in the absence of any clear, long-term signals for Phase III and beyond, that affected the decisions that they were making about their investment now, and basically they were saying that they would have to take decisions now about what to invest in and that the payback time for them would be beyond 2017 and there is no clear indication about what the price of carbon would be at that stage. They were saying that effectively it will just lead to them building more gas-fired power stations, and I just wonder how you are responding to those concerns.

  Mr O'Brien: Well, in a sense, they are right, but we do not want to build too much into that. Forward markets develop over a period of time and at the moment the carbon market, because it is linked so tightly to the energy market, has not got a long-term forward market built up yet, so, if you wanted to, say, work out what the price of forward purchase in 2017 is on the carbon market, well, you cannot do that very effectively because everyone knows that decisions are going to be made post-Copenhagen, whatever they are, and that, one way or another, is going to have an implication. In a sense, EDF are stating partly the blindingly obvious, but also I think that, if they are saying that means that, because we have not got a clear carbon price set for 2017 yet, we, therefore, cannot make a decision on whether to build a nuclear reactor, I think they are going to move towards building a nuclear reactor in any event. They have just invested £12.5 billion in buying British energy, so the idea that they are not going to do anything at all is, I think, probably unlikely. EDF are here because they want to make long-term profits in the UK in the energy market here, they see it as an enormously good market, we welcome them here, we want to see them do well as well as other companies, but the decisions that they make are not all going to be based on whether they can predict what the carbon price is going to be in 2017 when their first nuclear power station opens; I simply do not buy that.

  Q306  Joan Walley: But is there not as part of this whole debate a further issue, and you said just now that there was going to be this level playing field and that the Government was not going to be coming in and giving preferential treatment to certain aspects of different investments, but is it not the case that, unless the Government underwrites any or some of the extra costs—

  Mr O'Brien: Sorry, underwrites the extra costs of ETS or other technologies?

  Q307  Joan Walley: Are the people who are wanting to invest wanting to see exactly what these extra measures are that the Government will be bringing in alongside the price of carbon and the EU ETS?

  Mr O'Brien: Of course, every company that is making an advanced decision on investment on the scale that a company like EDF is making, particularly in the nuclear industry, would like to minimise the level of risk and have as many variables as they can turn into certainties. That is just a natural commercial wish, but it is also the case that companies are in the business of making commercial decisions to manage risk and there is always, always going to be a series of variables which they are, therefore, going to have to deal with in terms of making commercial decisions. Today it is the same as ten years ago and it will be the same in ten years. What they have, however, in this area is a clear government sense of direction, a broad level of stability in terms of political consensus, far more than exists in many other countries, which is why this country in many ways is a desirable country to invest in, and a clear sense of direction about where we are going and what we want to do and the broad role that an ETS will have. They do not need to have a carbon price fixed for 2017 in order to make a decision about investing in a nuclear power station.

  Q308  Joan Walley: But am I right in thinking that EDF have urged you to introduce carbon contracts that could underwrite the extra costs of low-carbon technologies and, if that is the case, what has your response been because it seems to me that that is more than just knowing what the long-term direction of government policy is going to be?

  Mr O'Brien: EDF would like to have more government support for a number of its projects. I suspect that, if we approached a number of other companies and we were suggesting that we would offer all kinds of support, they would say "Please".

  Q309  Joan Walley: When you say "more government support", would you just set out what that means?

  Mr O'Brien: Well, I think they would like any support they can get. They are making massive investments and they want certainty, predictability and whatever grants, support and incentives that they can get. That is natural, that is what every company in this area will want, but, from our point of view, what we have to do is ensure that we look after the interests of the consumer, we ensure that we deliver on the objectives of government policy in terms of climate change, that we do all of this at an affordable price and that we preserve energy security in the process, so we have got broad objectives too in terms of climate change, security and affordability. Those we have very much in mind and, when we talk to EDF, we look at what commercial decisions we think they are likely to make and they will have to make their own commercial decisions, and it is the same with them as for all the other companies. They would like, no doubt, to have the Government make life easier for them and, to some extent, we work with them, but we always have to bear in mind that the taxpayer/consumer are the people who put us here as a government and it is their long-term interests that we have to bear in mind in this, not necessarily how much profit a particular company, whoever it is, is going to make or what demands they make on the Exchequer to provide particular support for them.

  Mr Dodwell: We have listened a great deal to the views of energy companies and broader industrial stakeholders in the position that we have taken on the carbon market. When the review of the ETS came up, it was the UK that put forward a lot of the proposals that are designed to give industry long-term certainty. Certainty about the level of cap, in particular, was our number one priority during the negotiations and it was largely driven by a wish not only to get some environmental integrity so that you could see a future pathway, but also so that you would have that a predictable regulatory framework for business so that they would know what the demands would be, so we are well aware of those concerns. I think the issue actually that is forcing concern at the moment is that businesses are discounting for the risk of whether or not the EU will continue to go it alone if no one else moves forward on the international sphere, and they continue to see that as a risk that they cannot manage and, therefore, they discount it in their internal business decision-making process. As we have set out, there does seem to be a movement globally towards carbon trading as being the instrument of choice; there is a lot of interest in other developed countries and there is a lot of interest in developing countries as well in taking this forward, so we see a long-term future for that and the EU has set out its long-term vision. That, to an extent, is us moving and doing what we think is appropriate to respond to the concern about long-term signals and long-term carbon pricing, and that also underlies, in part, why we have taken such a positive and active position in the international negotiations because we see that we want to have a predictable international framework which complements what we are doing in the EU and that then can provide clarity and longer-term certainty to business globally about the direction of travel and about what policy levers are going to be in place in other countries as well as in our own.

  Q310  Mr Caton: During this inquiry, we have heard the argument that the ETS cap also acts as a floor on emissions, so the point was made to us that, if we in the UK cut our consumption of electricity, it will not cut emissions overall, it will simply leave the power sector with more allowances which, in turn, lower the carbon price and reduce pressure on industry. Do you see that as a problem and, if so, how do we deal with it?

  Mr Capper: In essence, the point you are suggesting is theoretically possible, but, if you have other measures in place that reduce emissions and you keep your cap level fixed, then of course there is less pressure within the system in terms of what the carbon price will be, and the carbon price may indeed be slightly lower. I think that this misses really the big picture, and the big picture is that the more emissions reductions you make, whether they are driven by the EU ETS or whether they are driven by these complementary measures on technology support, what it does is it allows you to move faster so that, when we come to the political debates around what the EU ETS cap should be post-Copenhagen, when we come to future debates about what the level of the cap should be within Europe or indeed within a linked global system, then, if you have already made the emissions reductions, it is going to be much easier to get tighter caps in the future and these measures then reinforce each other and pave the way for that low-carbon future that we are looking to deliver.

  Q311  Mr Caton: The non-government organisation that raised this with us, Sandbag, put forward a means of going faster, as you say, and they suggest that the Government ought to retain a reserve of ETS allowances which it would retire in response to additional efforts to cut emissions from the traded sector in the UK, thus actually lowering emissions below the initial cap. Is that a runner?

  Mr O'Brien: Sandbag have proposed in fact a number of mechanisms, including people buying themselves some of these allowances so that they can be, in effect, retired. Obviously, if it were done on a governmental scale, individual governments can reduce the amount of allowances circulating and, therefore, effectively reduce the cap. I think this is an interesting idea worth looking at, but what impact it would have on the market as a whole, I think, needs to be worked through, so I would not dismiss it as a concept. What I am wary about again is whether we are in the business of creating a political market or a commercial market and, if we are in a situation where the market price is going to be manipulated by the Government by this means of retiring various credits or allowances or indeed various other mechanisms, then the risk is that some who are involved in the market will say that that produces a level of uncertainty, so there would have to be some way of ensuring that the policy was clear as to how it would all be used if that were done, so I think it is an idea worth looking at. Their idea of individuals doing it, unless they were particularly wealthy individuals, is probably at the margin and that is why they are now looking at governments doing it, and I treat it with caution, but it is an idea worth looking at.

  Q312  Chairman: It is generally agreed that in Phase I too many allowances were allocated.

  Mr O'Brien: Yes.

  Q313  Chairman: During Phase I Britain purchased quite a lot of allowances. Does that raise the question of whether the effect of those did not actually achieve any emissions reductions at all?

  Mr O'Brien: Well, the objective was to produce a reduction in emissions. There are two questions: was there a reduction in emissions in the UK; and was there a reduction in emissions worldwide? There was an overall reduction in emissions, MIT's report suggests that that was the case, and it is the case that we took the view that we would want to see that reduction in emissions being effective. Now, did we do as much as we could in the UK? Well, we took the view that there was a significant reduction, it was not as massive as if we had not purchased the credits, for example, but overall there was a reduction.

  Q314  Chairman: But there is a flaw, is there not, in a system which allows offsets to be purchased from countries which do not themselves have a target?

  Mr O'Brien: It depends what you mean by a "flaw". Yes, we would like other countries to have targets and, yes, we would like them, at least in developing countries, to have sectoral targets and sectoral policies, but is it not right to encourage other countries to take steps which will reduce the level of emissions? Yes, I think it is right. It certainly was envisaged in Kyoto. The ETS rules allow provision of various offsets, whether offsets through CDMs outside the EU or various kinds of EU allowances and internal offsets, so our view is that we are dealing with a global phenomenon and, therefore, we need to recognise that. At the same time, we want to reduce domestically our emissions, but we also want to find ways in which we can encourage others to do so too. If, say, we denied access to the various allowances, credits, offsets, however you want to describe them, the UK companies would be disadvantaged, developing countries might not get the investment that they need in order to move towards a low-carbon economy, the reductions would occur perhaps more cheaply and, remember, an ETS is about delivering a reduction at the cheapest cost, so it could occur more cheaply, but it probably would not happen and, therefore, I think you have to have effective monitoring of these various offsets and we need to look at this whole area at Copenhagen, but you must not use the purchase of offsets as an excuse for doing nothing domestically.

  Q315  Chairman: Well, let us look ahead. Next year, your projections say that we will be a net purchaser of 24 million EU ETS allowances in 2010, and that is how we are going to achieve a reduction in our emissions. How many of those, do you think, will be bought as offset credits from outside the EU?

  Mr Capper: It is the $64 million question. How can you possibly know what companies' investment strategies will be over the next year? We simply do not know that information. What we do know is that in 2008 across the whole of the EU around 4% of all the allowances or credits that will be retired against the 2008 cap came from certified emissions reduction units or emissions reduction units from either the Clean Development Mechanism or Joint Implementation, so we know what the situation was in 2008. You would say in 2009 that maybe a similar level might be possible, but individual companies will take individual decisions and that will reflect in what the final outcome is.

  Q316  Chairman: So you do not mind what the proportion is?

  Mr Capper: I think, in terms of the EU as a whole, what we agreed in December is that we took a kind of in-principle view that at least 50% of the reductions should come from within the EU, so they should be domestic reductions within the EU and that the remaining up to 50% could come from the purchase of CERs or ERUs under the Clean Development Mechanism and joint implementation. I think that you have got to recognise that this is actually quite a big step forward in people's understanding of needing to get this balance right between domestic abatement and abatement that has perhaps been achieved overseas. If we just looked at what happened in Phase II of the EU ETS, one of the problems with Phase II of the EU ETS is that actually, by Member States all taking individual decisions on their national allocation plans within the EU ETS and those being approved by the European Commission, what we found was that, if you added up all the abatement offsets allowed by purchase from overseas, it came to 226% of the emissions reductions required in the system, so what we decided in December, collectively as the EU, is that we would change this 226%, which was far too high in terms of how many emissions could be bought from overseas, and we would reduce that over the period 2008 to 2020 to be at least 50% of the reductions occurring in the EU, so that is quite a significant shift in terms of the EU saying, "Actually, we need to have quite a lot of this abatement happening domestically over this period up to 2020".

  Mr Dodwell: As David has said, we are leading the debate again in Europe on the source of demand, but we are obviously interested in the supply as well as being interested in the quality of the offsets that are purchased, and we are addressing this on two fronts. Firstly, in terms of reform of the current CDM, we are very active in the negotiations and indeed our representative is a UK representative on the CDM Executive Board whose work is primarily aimed at improving the efficiency and the transparency of the assessment process, but at the same time we want to improve the effectiveness of the instrument, and we have been championing the use of sectoral benchmarks that allow you to effectively achieve additional reductions through still a project-based mechanism, but also in developing special approaches for some particular sectors where abatement will not be particularly cheap, and you will be aware of the HFC question, and that is something which we are actively pursuing in the negotiations. Also, we are advocating a move away from project-based systems, which effectively give credit against business as usual, to sectoral approaches, which have advantages both for environmental integrity, but also for financial flows for developing countries. You can cluster together individual projects, you start to look at them first programmatically, but then at a sectoral level and then you start to see some major increases in financial flows to those countries, but also, because you have set a benchmark that is considerably lower than business as usual, you are delivering much more in terms of emissions reductions. So we do recognise that the CDM itself needs to change as well as controlling, as David said, the demand for those credits.

  Mr O'Brien: The Stern Review of course took the view that these ought to be permitted, but monitored and looked at very carefully and should not be an excuse for failing to act domestically, and of course, from the Government's point of view, we are introducing carbon budgets across government and we have taken the view that the purchase of credits in the first place would not be something that we wanted to see.

  Q317  Chairman: Well, I welcome the recognition that the answers you have given reflect. One of the proposals in the US Waxman-Markey Bill has recognised that offsets are not really worth the same as cuts made within the cap, and it suggests that there will be a differential value and you would have to surrender five credits to cover four tonnes of emissions. Is that kind of approach one which you would like to see introduced into the EU ETS?

  Ms Duggan: I think actually that the amendment to the ETS directive, which takes account of 2020 to 2030,[3] does allow the EU to make those decisions about whether to discount certain allowances, and that is dependent on the outcome of the negotiations in Copenhagen, so, if, for example, CDM continued to allow allowances which, we felt, should not be recognised at full face value, then we would be able to discount them. I think that is what the Waxman-Markey Bill is still doing, particularly for international credits; it is allowing that ability, but it is not, depending on how its passage goes, necessarily going to continue through, and I think the domestic credits have already lost that discounting in the Waxman-Markey Bill.

  Q318  Chairman: But, as a principle, do you think that this is helpful?

  Ms Duggan: It is useful leverage perhaps to ensure the quality of credits that come through and, therefore, it is certainly useful to have the ability to discount them even if you do not actually have to use it.

  Q319  Colin Challen: The Government has agreed with the European Council in its non-legally binding declaration that auction proceeds or half of those proceeds should be spent on tackling climate change either at home or in developing countries. I am just wondering how that is, or will, work through in UK policy terms.

  Mr O'Brien: Well, we certainly accept that half, and probably more than that, are going to end up going into various kinds of projects to encourage a low-carbon economy, but the question really is: should we be hypothecating all the ETS auction revenue? Our view is that no, we are not going to directly hypothecate on a significant scale, but the EU rules, you are right, do say that at least half of the revenue should go on climate change issues. Also, additionally, there is the 300 EUAs, the allowances, which are helping to finance the 12 CCS projects and other technologies, something which we argued for, so that is quite significant. The Government also, over a number of years, but even in the Budget this year, has made clear that we want to put a lot of funding into projects. We are not sort of directly hypothecating it, but we are putting the money in in any event. We will not go through the normal Treasury arguments around hypothecation, but the question really is: is money going in in any event? There was the £405 million for the low-carbon technologies, the £335 million for the energy efficiency schemes and insulation schemes for homes and businesses, £45 million for micro-generation and other smaller schemes, £25 million for the community heating scheme and so on, so, even in the Budget this year, there was a recognition of the importance of ensuring that there was very substantial funding going in to helping the low-carbon technologies, dealing with issues around insulation and energy efficiency and delivering on the wider project of creating a low-carbon economy.

  Q320  Colin Challen: Well, President Obama's original proposal for cap and trade, and they talk about 100% auctioned, was to produce a tax rebate so that American taxpayers would get something back from those auction proceeds. Is that not a rather attractive idea? Have we looked at it and considered it? I am sure it might win a few votes for the incumbent Government. If people got their carbon cheques every year, would that not actually engage them in this whole debate in a way which at the moment the majority of people are not engaged?

  Mr O'Brien: Well, I listened with care to the advocates when the legislation was going through Parliament of feed-in tariffs and renewable heat incentives and the sorts of changes which we do think are needed to create incentives for people to develop low-carbon alternatives and technologies. We do provide particular subsidies for micro-generation now and we tend to do it in more than a slightly different way from the Americans, but, in our case, it is reasonably effectively targeted and what we will see, I hope, from April next year, when we introduce feed-in tariffs, is that we are providing a mechanism to encourage communities to develop their own technologies and in the longer term, in terms of the renewable heat incentive, I hope we will be able to do that the following year. There are different ways in which you can do these things. Traditionally, the Americans have done it simply by giving tax credits and we have tended to do it by a combination of means, the key one of which is by giving direct grants for particular outcomes; much more measurable, much more targeted. I think there are arguments for both, but we have taken the view that doing these things directly would be a preferable way because we know what we are getting for a certain expenditure of money. There have been various concessions from time to time of a smaller nature than the sort that Obama is now proposing in relation to various kinds of technologies and the development of them, particularly in terms of small companies getting tax benefits, tax credits, so there is an argument for this, but, given that there is always limited financing here, what is the best way of delivering the outcome, and we have taken the view that the ways we have chosen heretofore are the best ways.

  Q321  Collin Challen: The first two auctions have taken place. Have we learnt any specific lessons from the way that those have been handled and what has occurred?

  Mr O'Brien: Well, I think the auctions have actually gone very well. We had the first one on 19 November 2008 when four million allowances were sold. The price turned out then at £13.60, and the result that we got back was £54 million and it was four times over-subscribed, and I think the final point about the over-subscribed nature of them was an education and interesting. The one on 24 March this year sold a similar amount of allowances. The price came down to £10.12 on average and it was six times over-subscribed nonetheless as, remember, this is 24 March, well into the economic difficulties that we have had. On Thursday, we have got the third. We do not know what the price will be obviously, we will have to wait and see, but the amount will be much greater over the next year with 27 million allowances in eight auctions. I think we have learnt a number of things so far. We have set up the six primary participants who are investment banks and they are being encouraged to bring in various companies and installations who will seek to purchase the allowances, and it seems to have worked reasonably well. I think we are still discovering what the best way is of doing this. The Treasury have taken the view that there needed to be a greater incentive on the primary participants to encourage others to join the process of bidding, so there is now an incentive fee paid to the six to encourage them to bring in more bidders, but I think we have been encouraged by how well it has gone so far. It bodes well, I think, for the long term, but, before I start saying that it has all been a wonderful success, let us get Thursday out of the way.

  Q322  Collin Challen: So you would not want to hazard a guess as to how much might be raised in future auctions, particularly going into Phase III, an estimate?

  Mr O'Brien: Well, it depends on the price, so it would be simply a guess and I think it would be probably unwise to do so; let us see how this process goes. So far, I think you could say that we are extremely encouraged.

  Q323  Dr Turner: The European Commission has got a proposal that, "for advanced developing countries and highly competitive economic sectors, the project-based CDM should be phased out in favour of moving to a sectoral carbon market crediting mechanism". Do you know exactly what is meant by that, and do you think that it deals with the problems we all know about with improving additionality and verification of the existing CDMs?

  Mr O'Brien: The key problem with CDMs has been just making sure that they deliver what they are supposed to deliver, and I was very struck by the article in, I think it was, The Mail on Sunday over the weekend which looked at the way in which some of these markets are operating. We need to ensure that we can bring out some reforms of the CDMs, but I know that Chris wanted to say a word on this.

  Mr Dodwell: There are two things here, and one particularly relates to the point which was made about market shocks and the ability to expand the market, that this development needs to take place in a phased way where there is clarity about the amount of emissions that you are talking about and there are monitoring and reporting arrangements put in place before any kinds of benchmarks or targets are set by those sectors which effectively result in caps, so this is a progression over time. We would like to see these sorts of arrangements in place by 2020 with parties effectively having the option of taking them up in intermediate stages. The other is that these reforms need to be seen in the context of broader action by developing countries more generally and the European position on this, and indeed the UK position on this, is that developing countries need to be developing their own low-carbon development strategies, which can signal within them a broad level of ambition, decarbonisation, some sort of target that sets a level of ambition for the plans. Countries can then put forward proposals to the international community for sectoral trading, say, or for other policies for which they are seeking international support. Therefore, there is a complementary relationship whereby carbon finance and carbon markets can provide credits where you can set a credible sectoral benchmark or a sectoral baseline for a cap, but also where you have other policies which are being encouraged or incentivised by other public finance. So it is very much complementary to the overall position on climate finance. One of the things that we have been trying to do in terms of the international debate here is to say that the governance model needs to be looked at in terms of delivery of finance to developing countries to encourage low-carbon approaches, and the UNFCCC and the other arrangements which are currently in place were not designed to handle the levels of financial flows that we are talking about here. In terms of how actual markets might work, how a sectoral crediting system might work, we have got some experience of that in the UK. We have done a similar approach for the climate change agreements where they operated on a sectoral credit baseline and credit approach whereby, at the end of a period, you would effectively receive a sector-received credit if it beat the negotiated benchmark. A trading approach actually is very similar to a cap and trade approach that you have in the EU in that you receive the allowances upfront, so there are advantages from the perspective of the companies that are regulated in that they receive the allowances upfront and they can start to consider how to behave with those allowances, so this is an evolution away from project-by-project-based approaches whereby you move to something which is more sectoral, as I was mentioning earlier, where the benchmarks can reflect some real effort. There are a number of different models that are under development as to how the detail of the systems would work.

  Q324  Dr Turner: So do you think that this could be of any value? For instance, if, let us say, India and China do not want to sign up to a global regime with a binding cap, do you think they would be more prepared to sign up their major industries to sectoral schemes?

  Mr Dodwell: Well, that is our objective. The Chinese have begun to make announcements which suggest that they are open to this idea and they have been talking about, in their next five-year plan, extending that perhaps for a ten-year time horizon and having a carbon intensity target for the whole of the Chinese economy. They have also indicated that they are interested in discussing, as have other developing countries like South Africa, how these sorts of sectoral approaches might work. What we need to do here is to build incentives into the system so that you are not reliant on harsh compliance penalties which, as we know, do not operate particularly effectively at the international level and, instead, there is an incentive for participation and an incentive for countries to take more ambitious action.

  Mr O'Brien: What the countries like India, China, South Africa and so on are looking for is more funding to come from Western countries in order to fund all of this, and that means that there is an ability to encourage the development of a sectoral approach in their countries by us, providing that it is done in a way which actually delivers change. Now, the difficulty of course is that the funding mechanism for that, CDMs, at the moment we have got concerns about the administration, the transparency, the methodology behind it and how the CDM Executive has been undertaking its responsibilities. We sought some reforms at Poznan and did not get very far with that. There are clearly quite worrying aspects of it around HFCs in China and the way in which the Chinese have now decided to tax the money going into China because there is so much money going in, so there is clearly a need for significant reform of the CDMs. A sectoral approach could give us the ability to carry out some of those reforms, but it will not be easy to put in place and, I suspect, we are not talking about this happening in the next year, but this will take some time to negotiate, to put in place and also to work out what sort of funding streams from Western countries would deliver the results that we want to see.

  Q325  Colin Challen: The DECC memo to this Committee[4] says that the CDM "helps to drive global investment in low-carbon technologies" and supports developing countries in moving away from high-emitting `business as usual' developments. What proportion of CDM investments are actually going to low- or zero-carbon technologies as opposed to something which is merely just more efficient, like coal plants that are being built today?

  Mr O'Brien: Certainly, much of it is going into more efficient rather than very low or zero. As we know, there is probably no zero.

  Mr Dodwell: I do not have figures on the sectoral split, but we can do what we can to provide the material.[5] I think it is quite difficult to get a complete, holistic view and, in particular, your categorisation of sort of mainstream technologies rather than transformational technologies. It was partly with this in mind that last year we set up the Climate Investment Fund with other G8 countries and other countries contributing to them because we recognised that, just as in the UK you can have a carbon price that kind of exists and which changes behaviours, but does not necessarily get to the transformational technologies that you need, so that happens with the CDM and, indeed, even if you have a broader carbon price. That is why we set up the Clean Technologies Fund which now has had a number of bids which have come in, been reviewed and some of them in fact just been approved, I think country investment plans where you have effectively got a country like Mexico coming forward with a real transformational plan as to specific initiatives where it needs funding from the international community to put in place. I believe that the Mexican plan is something in the order of $500 million. Now, the CDM last year was worth $6.5 billion, so that is the amount of money that is actually going into developing countries, and that was down a little on the previous year, so these two things need to operate in a complementary way. Just as we were saying with UK policy you need to have both things that encourage the efficient use, the sort of smaller changes, you also need support for the big, transformational changes.

  Q326  Colin Challen: So our position, the Government's position, on using the CDM is to support maybe more efficient fossil fuel-based technologies, do we not really take a view on that, or do we rather tend not to support it because we have this other mechanism?

  Mr O'Brien: Well, if we can encourage the development of CCS or if we can develop the technologies which are going to ensure that developing countries are able to both develop an increasing rate, but also do so without increased emissions, then that is something that we are not unhappy about, but I think there is a real risk here that, if we try to be overly prescriptive, we could reduce the opportunities for people to become involved in this kind of investment. The price of doing that may well be significant because we could, at a reasonably low cost, reduce the amount of emissions from some developing countries. This is probably, of all the issues across the area of the ETS, the most difficult one because we know that this is a global problem, we know that it does not matter where the reduction happens and, in a sense, we just need the reduction to happen and it needs to be permanent. You can probably do it more cheaply in developing countries, but we also need to know that we are the main polluters and we need to make sure that we are the ones that set the lead and make the cuts here. In terms of how we help developing countries, we want to help them to develop low-carbon technologies, but that does not mean zero-carbon technologies, it means lower and low, both.

  Q327  Chairman: Thank you very much. We have covered a bit of ground this morning and we are very grateful to you and your officials for coming in, and I am sure we shall reflect a lot of what you have said in our Report.

  Mr O'Brien: Thank you, and can I just say thank you to my officials for the briefing I have had from them.

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1   Note by Witness: The EU ETS market was worth €63 billion in 2008, and the global market was worth €86 billion. Back

2   Ev 80 Back

3   Note by Witness: The witness meant to refer to the ETS directive, taking account of 20-30% by 2020. Back

4   Ev 127 Back

5   Note: See Ev 144 Back

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Prepared 8 February 2010